Euro Crisis Risks Eliminated?

I still don’t think the Euro crisis has truly ended. Yes, it looks like we’ve stumbled upon a temporary patch, but from a more macro perspective it’s hard to see that this is a real fix. What remains unresolved is the lack of a permanent fix in the currency union. The ECB has managed to bring private bidders back to the markets, but that’s all largely contingent on economic stability.

I am still having trouble with the basic math here and seeing how more fiscal austerity will generate enough growth to outpace debt growth. It looks to me like we’re in a position where the governments on the periphery will continue to miss deficit targets and debt will remain extremely high, growth will stagnate and civil and political unrest remains the surest risk to causing an unraveling.

That said, I really like this Citi note on the risks remaining in Europe:

“The market seems ever more comfortable with the sense that the central banks have now effectively quashed the macro risks for the foreseeable future. It is certainly true that 2012 saw past ‘red lines’ shift significantly. As the German election has drawn nearer, Merkel has made considerable concessions on the
Greek bailouts and on banking union and recapitalizations. Even more significant perhaps is the shift in the ECB’s approach from the dogmatic Trichet to the much more pragmatic Draghi. Both have removed some of the constraints that threatened to break EMU not long ago.

But regardless, macro risk will never be far away in our view. It is Citi’s central scenario that there will be some form of sovereign restructuring in all five periphery countries by 2017, and Grexit in the next 12-18 months.

Granted, the kind of sovereign debt restructuring they envisage for countries like Italy and Spain is very different to what happened in Greece – comprising maturity extensions and coupon reductions, rather than large haircuts to principal. However, the transition towards that outcome will almost inevitably hold lots of uncertainties for financial markets. Restructurings may not occur this year, but any number of macroeconomic events could well tilt market expectations in that direction temporarily. Already this year, our economists believe the unsustainability of the debt level in Portugal will become increasingly apparent.

The immediate path towards bail-out programmes for Spain and Italy per se is not our principal concern. However, the reaction of the market and the rating agencies to the trajectory of several periphery economies implied by Citi’s forecasts creates significant downside risks in our view.

For instance, the Spanish government’s deficit targets of 4.5% in 2013 and 2.8% in 2014 are far more optimistic than Citi’s forecasts of 6.4% and 5.8% – largely due to our expectation that the economy will contract by 2.4% and 1.9% respectively over the next two years – far more than what is assumed in the Spanish budget. Based on current initiatives taken by the Spanish government, the European Commission
forecasts an even bigger deficit of 6.4% in 2014.”